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Tax Reform Better Be HUUUGE…

US corporate tax rates are among the highest in the world, but reforming them won't be easy...

Economist, Author, and Five Star Wealth Manager

Ivan Illán has excelled in both institutional asset management and financial advisory for more than 20 years. Ivan’s work has been featured in numerous articles including, The Washington Post and The Wall Street Journal. He’s a Forbes Contributor and Finance Council Member. Ivan is also ranked as a Financial Times Top Financial Adviser. He holds degrees in finance and philosophy from Boston College, the Certified Fund Specialist (CFS®) designation from the Institute of Business & Finance, and is a member of the CFA Institute, New York Society of Security Analysts, and CFA Society Los Angeles, where he’s a Founding Member of the Wealth Management League.
Ivan Illán has excelled in both institutional asset management and financial advisory for more than 20 years. Ivan’s work has been featured in numerous articles including, The Washington Post and The Wall Street Journal. He’s a Forbes Contributor and Finance Council Member. Ivan is also ranked as a Financial Times Top Financial Adviser. He holds degrees in finance and philosophy from Boston College, the Certified Fund Specialist (CFS®) designation from the Institute of Business & Finance, and is a member of the CFA Institute, New York Society of Security Analysts, and CFA Society Los Angeles, where he’s a Founding Member of the Wealth Management League.

As the S&P 500 Index sits around a 25 Price-to-Earnings (P/E) Ratio (based on trailing 12 month earnings), investors have been forced to ask the question: are stocks overvalued? The answers is: it depends. If Congress fails to pass laws that will fulfill campaign promises, then the market is overvalued. On the other hand, if we get new reforms on tax policy and some fiscal stimulus, then the Forward P/E ratio of 18 is a good value, and stocks today are not only well-priced, but may even be undervalued today.

The discussed tax reform from the Trump administration includes a 15% top-tier corporate tax rate. August 2017 is the timeframe indicated for a full reveal on the proposed law. A 15% rate would be a big move from the current top-tier 39.1% (35% federal rate, plus a combined state tax). On the surface, this looks to be a very HUUUGE break for all businesses, both large and small. The stock market has baked into its current market price a high probability of achieving this level of adjustment. Upon closer examination, the market might be overly simplifying the impact of a lower corporate tax rate, and not placing more or at least equal importance on individual tax reform.

In a report to Congress from March 2016 from the US Government Accountability Office, entitled “Most Large Profitable US Corporations Paid Tax but Effective Tax Rates Differed Significantly from the Statutory Rate”, we find some very elucidating information. For starters, most businesses are already paying much less than the top-tier tax rate. From 2008 – 2012, the corporate effective tax rate averaged 14%. In many instances, certain businesses pay no tax at all, based on federal accounting rules. From a government total revenue standpoint, corporate income tax represents only about 15% of total receipts. Compared to the individual income tax receipts, which are more than 50% of federal tax revenues.

A recent Wall Street Journal article, highlighted findings from the Congressional Budget Office, including this very striking chart below. In short, even though the US does indeed have one of the highest corporate tax rates in the world, when you look at the actual tax paid, it works out to a much lower figure. In 2012, the effective tax rate was around half the top rate at 18.6%. So, if the stock market is betting on lower corporate taxes, and companies are already pretty close to 15%, does that mean they’ll get an effective corporate tax rates closer to 7%? If we don’t see changes to the deductibility of certain corporate expenses like debt interest expense or capital expenditures, then yes. And, we’ll see a very happy stock market. But, if a lower rate comes with a loss of deductions, then we won’t find our corporations in a greatly improved earnings position due to tax savings, which is a direct hit to current market prices and expectations.

Bottom-line: The Trump administration should focus as much effort on reforming individual taxation, which is a much bigger revenue component, and a much bigger impact on GDP. Most individual tax savings would be spent on personal consumption adding further to increased corporate earnings.